A good beta will, therefore, rely on your risk tolerance and goals. If you wish to replicate the broader market in your portfolio, for instance via an index ETF, a beta of 1.0 would be ideal. If you are a conservative investor looking to preserve principal, a lower https://www.investorynews.com/ beta may be more appropriate. In a bull market, betas greater than 1.0 will tend to produce above-average returns – but will also produce larger losses in a down market. One way for a stock investor to think about risk is to split it into two categories.
One such sector is consumer retail, which is dependent on frequently shifting consumer sentiment. Beta analysis can be a useful way to manage the level of risk in your portfolio, but like any financial technique, it’s not perfect. Yahoo Finance’s beta calculations are based on monthly returns over the last five years, while FinViz doesn’t specify the data it uses to calculate beta. Or, even easier, you could just look up a stock’s beta online. For the rest of us, it’s much easier to calculate beta in spreadsheet programs such as Microsoft Excel or Google Sheets, which have built-in variance and covariance formulas.
Beta is a mathematical term that measures how risky a stock is compared to the entire market. The value of Beta can be positive or negative depending on the stock in question. For example, the β of most technology companies tends to be higher than 1. Also, a company with a β of 1.30 is theoretically 30% more volatile than the market.
How Beta Works
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It may be inclined to hold its value on a bad day or get stuck in a rut when most stocks are rising. Besides, beta offers a clear, quantifiable measure that is easy to work with. Sure, https://www.forex-world.net/ there are variations on beta depending on things such as the market index used and the time period measured. But broadly speaking, the notion of beta is fairly straightforward.
Similarly, a β of more than 1 indicates that the security is more volatile than the market as a whole. Companies in certain industries tend to achieve a higher β than companies in other industries. It’s not a forward-looking metric, so take the time for fundamental research to augment your analysis. If its beta were less than 1, it would be expected to be less volatile than the index — smaller increases and decreases. So a stock with a beta of 0.7 would rise by 0.7% on a day that the S&P 500 rose 1%, and would fall by 0.7% on a day that the S&P 500 fell 1%. If its beta were greater than 1, it would be expected to be more volatile than the index — in other words, bigger increases and decreases.
Beta: Definition, Calculation, and Explanation for Investors
The beta of an asset is compared to the market as a whole, usually the S&P 500. By definition, the value-weighted average of all market-betas of all investable assets with respect to the value-weighted market index is 1. Beta is the hedge ratio of an investment with respect to the stock market. For example, to hedge out the market-risk of a stock with a market beta of 2.0, an investor would short $2,000 in the stock market for every $1,000 invested in the stock. Thus insured, movements of the overall stock market no longer influence the combined position on average.
Their future is unpredictable and that leads to lots of speculation and price movements. A beta that is greater than 1.0 indicates that the security’s price is theoretically more volatile than the market. For example, if a stock’s beta is 1.2, it is assumed to be 20% more volatile than the market. Technology stocks and small cap stocks tend to have higher betas than the market benchmark. This indicates that adding the stock to a portfolio will increase the portfolio’s risk, but may also increase its expected return.
- Adding this type of stock to a portfolio lowers the overall risk but has a similar effect on potential return.
- Beta says nothing about the price paid for the stock in relation to fundamental factors like changes in company leadership, new product discoveries, or future cash flows.
- While a stock that deviates very little from the market doesn’t add a lot of risk to a portfolio, it also doesn’t increase the potential for greater returns.
- The most rudimentary way to use beta is to realize that high beta stocks could increase your portfolio risk while low beta stocks could reduce it.
- You don’t need to do college-level statistical calculations by hand to find a stock’s beta (unless you want to, for some reason).
- Next, calculate the daily price changes for each (subtract current day price from previous day price, divide by the previous day price and multiply by 100).
However, a high Beta stock is also likely to be more volatile than the overall market. This puts high Beta stocks in the high-risk, high-reward category. Traders & investors must thus evaluate their risk profile before adding high Beta stocks to their portfolios. A stock with a very low beta could have smaller price swings, yet it could still be in a long-term downtrend.
The Calculation for Beta Is As Follows:
Theoretically this is possible, however, it is extremely rare to find a stock with a negative β. Low β – A company with a β that’s lower than 1 is less volatile than the whole market. As an example, consider an electric utility company with a β of 0.45, which would have returned only 45% of what the market returned in a given period. These have some similarity to bonds, in that they tend to pay consistent dividends, and their prospects are not strongly dependent on economic cycles. They are still stocks, so the market price will be affected by overall stock market trends, even if this does not make sense. That is, if a portfolio consists of 80% asset A and 20% asset B, then the beta of the portfolio is 80% times the beta of asset A and 20% times the beta of asset B.
A low Beta generally means that a stock is likely to fall under the low-risk, low-return category. On the flip side, a high Beta stock falls under the high-risk, high-reward category. Some stock traders are known to prefer high Beta stocks while certain stock investors are inclined to choose low Beta stocks. For a company with a negative β, it means that it moves in the opposite direction of the market.
Understanding Beta in Investing
The OLS regression can be estimated on 1–5 years worth of daily, weekly or monthly stock returns. Estimators of market-beta have to wrestle with two important problems. First, the underlying market betas are known to move over time. Second, investors are interested in the best forecast of the true prevailing beta most indicative of the most likely future beta realization and not in the historical market-beta.
Examples are hypothetical, and we encourage you to seek personalized advice from qualified professionals regarding specific investment issues. Our estimates are based on past market performance, and past performance is not a guarantee of future performance. Low beta generally means lower price volatiltiy than the average stock. https://www.dowjonesanalysis.com/ At the same time, many technology stocks are relatively new to the market and thus have insufficient price history to establish a reliable beta. A stock’s price variability is important to consider when assessing risk. If you think about risk as the possibility of a stock losing its value, beta has appeal as a proxy for risk.
The most rudimentary way to use beta is to realize that high beta stocks could increase your portfolio risk while low beta stocks could reduce it. High beta stocks make portfolios riskier but increase the chance of higher returns. Finally, calculate the variance of the index (derived from the index daily price changes to show how they are distributed around the average), and divide the covariance by the variance. Beta is a way of measuring how volatile an investment is, compared with a market index such as the S&P 500. It’s used to evaluate the expected risks and returns of a portfolio, or to see whether a specific investment would be a good fit for a portfolio in terms of expected risks and returns.
For example, a gold company with a β of -0.2, which would have returned -2% when the market was up 10%. High β – A company with a β that’s greater than 1 is more volatile than the market. For example, a high-risk technology company with a β of 1.75 would have returned 175% of what the market returned in a given period (typically measured weekly). Unsystemic risk is unique to each security and can be diversified away in an investment portfolio.
